Are High Yield Bonds Flashing a Warning for Stocks?

Here's why the smart money is starting to get nervous

By Daniel Putnam, InvestorPlace Contributor

If the bond market is indeed the “smart money” of the investing world, equity investors should pay attention to the recent underperformance of high-yield bonds.

Stocks and high-yield bonds typically move in similar directions, so any divergence between the two is a signal that bond owners may be seeing something that stock investors aren’t. One such divergence has taken place during the past month, with high yield bonds falling in price even as stocks have continued to move sideways. Is this the proverbial canary in the coal mine for equities — are we heading for a market correction?

A Fork in the Road

The accompanying chart shows that stocks and the iShares iBoxx $ High Yield Corporate Bond ETF (HYG), after trading largely in tandem in the bull market of the past year, are now moving in opposite directions. Since June 34, the HYG has fallen 1.16%, while the SPDR S&P 500 ETF (SPY) has eked out a gain of 1.36%. While the magnitude of the gap may be small, in this case it’s the direction that counts.

high yield market correction

HYG vs. S&P 500, 3-month chart

Notably, this has occurred against a backdrop of falling Treasury yields. (Keep in mind, prices and yields move in opposite directions.) The 10-year yield closed at 2.47% on Monday, down from 2.65% on July 3. This indicates that the slump in HYG has been entirely a result of rising yield spreads — a sign that investors have required more compensation for the attendant risks.

Indeed, the BofA Merrill Lynch US High Yield Master II Option-Adjusted Spread tracked by the Federal Reserve Bank of St. Louis has climbed from 335 basis points (3.35 percentage points) on June 23 to 378 on July 18 — a sharp reversal of the trend that has been in place throughout the past year.

Why Does This Matter?

The divergence between the performance of stocks and high-yield bonds has only been in place for about a month, so it’s no sure sign of a market correction. But it merits attention nonetheless. The high-yield bond market is acutely attuned to credit conditions, and it has been a harbinger of trouble in the past.

The most glaring example occurred in 2007.

As shown in the accompanying chart, the high yield market — as represented by HYG — began turning south about one month before the stock market suffered its first, pre-crisis breakdown in July of that year. This isn’t to say that we’re headed for a similar bear market in equities this time around. However, the similarity warrants attention among those holding shorter-term long positions.

high yield market correction

HYG vs. S&P 500, May-June 2007

Two Important Caveats

While it’s never wise to claim that “It’s different this time,” there are two important reasons why the recent weakness in HYG could be written off to causes other than worries about credit conditions.

First, as covered here, high-yield bonds came into the summer with exceptionally low yield spreads versus Treasuries. This left little margin for error, and it made the market vulnerable to routine profit-taking. This may be all that we’re seeing right now.

Second, the tighter regulations on financial institutions have forced dealers to exit the high-yield market, causing liquidity to dry up. This makes the market much more vulnerable to the type of heavy retail outflows from high yield mutual funds and ETFs that has occurred so far this summer.

According to’s fund flows tracker, HYG has suffered the third-highest outflows of any U.S. ETF thus far in July, with $932 million having exited the fund. PIMCO 0-5 Year High Yield Corporate Bond (HYS) is has experienced the sixth-highest redemptions, at $596 million. With reduced liquidity in the market, there is wider latitude for these types of fund flows to create false signals.

The Bottom Line

These qualifiers aside, it looks as though the high-yield market is trying to send a message to equity investors. In combination with the softness in retail stocks and the potential double-top in small caps, it’s become increasingly clear that investors need to tread carefully as we move closer to the time of year — early autumn — when the stock market is most likely to experience volatility.

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